Impact valuation is an emerging concept. Although companies understand the need to move beyond environmental footprinting and onto valuing their societal impact, many are still struggling to determine what they should be measuring and how, and how they can go about converting this to financial terms. Sustainability Investing Analyst Rashila Kerai explains why impact valuation is important to both companies and investors, and highlights some of the key findings from this year’s new Impact Measurement and Valuation criterion.
Sustainability Investing Analyst
Companies are increasingly facing pressure from a range of stakeholders including customers, employees, local communities, governments, and investors to make a positive contribution across the triple bottom line. Not only are companies expected to move from “doing less harm” to doing more good, they are also expected to continue to deliver financial returns. Increasingly, investors, particularly institutional investors and pension funds, are also under pressure from their beneficiaries to deliver investment strategies that generate positive societal impacts alongside financial return. In order to succeed, companies must understand how value is created and diminished, and use this information to better mitigate risks and harness opportunities. In turn, this needs to be communicated to investors to help them understand the significance of the impacts and how the company is positioning itself. But what exactly is meant by impact?
In order to succeed, companies must understand how value is created and diminished, and use this information to better mitigate risks and harness opportunities.
What is impact?
Figure 1 represents a highly simplified impact pathway. Companies track their activities and inputs needed to generate their products and services. Besides a company’s products and services, other outputs include any waste and other by-products generated during the course of doing business. Impacts, or externalities, are the resulting consequences or effects of these outputs − both intended and unintended, and positive and negative − for society and environment at large.
Figure 1: Impact pathway
Limitations of current reporting
Today’s sustainability reporting only tells a partial story. Companies have gotten quite good at tracking their sustainability activities and reporting on inputs such as water use or outputs such as emissions, but they generally stop there. This means that the social and environmental impacts of companies’ activities such as the ones depicted in the impact pathway examples in Figure 1 are invisible.
Moreover, outputs are reported in disparate units, making it difficult to understand the relative significance of these outputs. For example, how can a company compare the importance of its m3 of waste generated to tons of NOx emissions? As stand-alone figures, a company’s tons of emissions lack enough context to inform its business decisions. How can a company use this information to decide whether it should invest in reducing its emissions or focus on reducing waste? One way to make better use of this data is to measure the actual impact of these externalities and convert these disparate impacts into a common financial metric that enables better decision making.
Likewise, most financial reporting does not paint a complete picture of a company’s real value; it is typically limited to a company’s financial earnings and the economic value generated for beneficiaries such as employees, governments, shareholders and creditors, and excludes the environmental and social value generated or destroyed by a company’s activities. But if a company were to internalize its material externalities by quantifying environmental and social impacts in financial terms and view these alongside its financial reporting, its real value would look quite different, as shown in Figure 2.
If a company were to internalize its material externalities by quantifying environmental and social impacts in financial terms, its real value would look quite different.
Figure 2: Adding it all up: how social and environmental impacts affect real value
Why does impact valuation matter?
What if companies could see the extent to which value is created and diminished in a consistent, comparable way? A more inclusive way to measure company performance encompassing not only financial value, but also social and environmental value could highlight the key levers to grow the positive and reduce the negative impacts. For businesses, this means knowing what their material issues are and understanding the magnitude of the associated risks and opportunities.
By understanding what part of their value chains are associated with their greatest environmental and social impacts as well as the magnitude of such impacts, companies can also begin to understand some of the risks associated with their negative impacts. Likewise, by understanding which of their activities generate the most positive impacts, companies can identify opportunities for innovation. This can also help companies understand the various trade-offs involved when making different business decisions.
Monetizing impacts translates sustainability into the language of business.
Having better insights into the value of one’s impacts can potentially lead to different corporate decisions than those being taken today. These insights can enable a deeper understanding throughout the organization of the importance of sustainability to the business value drivers, thereby integrating this into capital allocation decisions for different projects, changes in raw materials used or the products and services offered.
In short, giving visibility to the significance of impacts enables a company to take better decisions to minimize its negative impacts and maximize its positive impacts, ultimately leading to a deeper integration of sustainability into the long term strategy of the company.
The investors’ perspective
Investors are also interested in how companies measure and understand their impacts, and more importantly, how they use this information in their internal decision making so that it leads to long term value creation. But in order achieve this, investors also need decision-friendly information converting disparate units of output into consistent and comparable information in order to evaluate:
- The influence of the social and environmental externalities on business value drivers (growth, profitability and risk)
- Financial and extra-financial information alongside each other
- Companies’ competitive advantage
Monetizing impacts translates sustainability into the language of business and supports this need.
Why we introduced the impact valuation criterion
Leading companies have realized the limitations of the current measurement and reporting approaches and are already calculating their social and environmental Profits & Losses (SE P&L) with the aim to enable better decision making. The launch of the Natural Capital Protocol1 in 2016 and the upcoming publication of the Social Capital Protocol2 later this year are expected to lead to greater uptake.
Recognizing that impact valuation is an emerging topic, RobecoSAM introduced some basic questions for some of the industries in order to:
- Reward and recognize leading practice
- Gain insights into what companies are doing and why
We asked companies three very simple questions:
- Are you conducting impact valuation of your externalities?
- What type of valuation?
- Do you disclose this information?
1 Natural Capital Protocol leverages existing measurement tools and methodologies to develop a standardized framework to help companies identify, measure, and value the impacts of their activities on environmental resources − or natural capital. The framework aims to generate information that enables companies to consider their impacts on natural capital when making business decisions.
2 Led by the WBCSD, the Social Capital Protocol aims to develop a harmonized approach to measuring and valuing companies’ interactions with people and society.
What have we learned so far?
We evaluated responses from 184 companies from 15 industries in 30 countries. The industry coverage is quite diverse, ranging from heavy manufacturing to consumer facing companies, asset heavy or light, companies with complex supply chains or simpler supply chains, and geographically diverse with representation in all regions.
Figure 3: Companies evaluated on impact measurement and valuation
Of the companies evaluated, almost 80% reported that they measure and value their impacts. However, when we analyzed the valuation examples they cited in their responses, we found that in fact, only 25% of these companies actually do value their impacts (they report Yes, and Yes, we agree). This leaves more than 50% that report Yes, but No, we do not agree they are valuing their externalities. Another 10% of the companies are either developing or testing an impact valuation methodology.
Figure 4: Impact valuation: what companies think they are doing, and what they are actually doing
Why such a big gap between what companies report and what they actually do? The disconnect can be explained by a lack of understanding of what impact valuation really means, which is reasonable given that it is such an emerging topic. As awareness grows and companies increasingly understand the need to move from outputs to impacts, we expect this gap to narrow.
Responses from companies in the “Yes but No” group related to inputs or outputs (i.e. the first and second steps of the impact pathway depicted in Figure 1) and mainly fell into one of the three categories below:
- Environmental footprint (e.g., avoided/reduced emissions, material/energy efficiency, or CapEx/ OpEx to improve environmental performance)
- Philanthropy or community engagement (e.g., volunteering activities, monetary investments)
- Revenues from more sustainable products (e.g., recyclable, degradable, reduced raw materials, reduced hazardous substances, increased recycled or renewable content)
The 25% of companies that are valuing their impacts are using one of the many existing methodologies or applying the Natural or Social Capital Protocols to measure environmental and/or social impacts. Some companies are internalizing some of the externalities through the use of shadow pricing.
* Yes, and Yes: companies reporting that they value their impacts, and Yes, we accepted their response
** Yes, but No: companies reporting that they value their impacts, but No, we do not agree that they are valuing their impacts
Where is the leadership?
Figure 5: Percentage of companies in each industry conducting impact valuation
More than 30% of companies we evaluated in the following industries are conducting impact valuation: beverages, chemicals, construction materials, media, and textiles, apparel & luxury goods. While it is not clear why this is the case, we can see that the leadership is coming from a diversity of companies, spanning from consumer facing industries to heavy manufacturing.
The motivation for companies to undergo this type of valuation confirms our expectation: companies felt they needed insights that are more inclusive of sustainability factors to enable better decision making. This includes strategy setting, measuring and improving performance, CapEx allocation, product development, and supply chain management.
What is really interesting is that generally, if companies undertake impact valuation, the majority (65%) are monetizing. This makes sense. Once companies have gone through the effort of identifying the appropriate techniques and collecting the data needed for the valuations, it is a relatively small incremental step to monetize the impacts. Companies then have comparable information across material economic, social, and environmental issues. It’s a language easily understood across the company. It is also a language easily understood by investors and therefore our preference is that impacts be monetized.
Monetizing impacts gives a fuller picture of corporate value created today and into the future.
Only 31% of companies disclose their valuations. This reluctance confirms that they do this for their internal management and direction setting rather than for communication or reporting purposes. But just as impact valuation can help companies increase the understanding of their material issues internally, it can also help companies inform investors about their sustainability impacts and what they are doing in response.
The concept of impact valuation is a new and emerging topic. With initiatives like the Natural and Social Capital protocols, which are working to improve companies’ understanding of what impact valuation entails and provide companies with tools and resources to carry out valuations, we expect to see an increase in companies conducting environmental and social P&L accounting.
As more and more companies undertake this analysis to deepen integration of sustainability into the business, we encourage companies to also disclose and share this with investors. Monetizing these impacts enables comparability across economic, social, and environmental dimensions, bringing the invisible issues more directly into the picture, and therefore gives a fuller picture of the value created today and into the future.
Akzo Nobel: 4 Dimensions of Profit & Loss
Director of Sustainability, Akzo Nobel
A new way of looking at value creation and a company’s impact on society and environment
For specialty chemicals company Akzo Nobel, business is sustainability and sustainability is business. This means understanding its societal role and looking at how as a company it can contribute across a broad sustainability agenda: namely, financial, natural, social, and human capital. Since 2014, Akzo Nobel has been measuring and monetizing its positive and negative impacts on each of these four dimensions using its 4D Profit & Loss (4D P&L) methodology. We spoke to André Veneman, Akzo Nobel’s Director of Sustainability to learn about their motivations for developing this impact valuation approach, and how it benefits the firm.
“Mainstream investors appreciate our 4D framework because it helps them understand a truer picture of the company performance.”
Rashila Kerai: Why did Akzo Nobel decide to develop the 4D P&L?
André Veneman: Sustainability is our company’s strategy and our 4D P&L approach helps us bring this to life. The 4D P&L began as an internal guidance and engagement tool to help our organization understand sustainability and where and how value is generated and diminished in our value chain. For each capital, we have monetized the material issues, allowing us to see where the contributors to positive and negative impacts are. In turn, this helps us translate our strategy into concrete terms that all areas of the business understand and can use. With this knowledge, our employees are empowered to identify and evaluate the levers for the most effective impact, and ultimately, increase business value.
How do you use these insights within the organization?
Our employees report that it’s eye opening to think of impacts in terms of virtual price, and having this holistic view helps our managers make better-informed decisions. The four capitals are viewed separately to ensure that the impacts are clearly understood, and keeps the focus on improving our performance on each dimension so that there is no trade-off between one capital and another. Over the years, we have refined and improved our methodology and today, it provides a consistent, comparable, replicable view of our overall performance year-on-year. The 4D P&L has proven to be a valuable tool to guide internal discussions because it speaks in the language of business.
The 4D approach has also created a sense of pride and inspiration among our employees by demonstrating our commitment to sustainability and allowing us to transparently show the sources of value creation.
How does this information help you engage with investors?
We use this framework to discuss our performance and value generation with investors. Mainstream investors appreciate this because it helps them understand a truer picture of the company performance, particularly when we can show shareholders where the biggest risks are and how we are responding.
How do you see your impact valuation methodology evolving?
We’re not done yet. The 4D P&L provides us with useful insights across our activities and operations. Going forward, this could be extended to measuring the social value our products deliver, and we are currently participating in an industry-wide initiative to tackle this.